Saudi-Russian price war leaves US oil sector exposed

March 20th 2020 | Multiple countries | Oil and gas

The failure of OPEC and Russia to extend their three-year supply cut agreement has focused attention on the US in its newly found role as a leading global oil producer. The sharp growth in American oil output has brought geopolitical and economic dividends for the US, but its narrative of "energy dominance" will be tested by Russia's abandonment of efforts to shore up prices and Saudi Arabia's swift response to hike output. With Russia and OPEC no longer co-operating as oil demand plunges amidst the COVID-19 pandemic, the US oil sector is vulnerable to circumstances that are out of its control, leaving it exposed it to the actions of other producers who wish to exercise their own geopolitical agenda.

US becomes the top crude oil producer

Over the last decade US oil production has more than doubled due to fracking, which has unlocked vast resources of hydrocarbons found mainly in shale rock formations. In 2019 US crude oil output reached 12.2 million b/d, up from 5.5m b/d in 2010, almost totally due to the increase in production of shale and light, tight oil. US crude oil output now exceeds that of Russia and Saudi Arabia.

Higher production and rising exports of crude oil and products have also virtually eliminated US dependence on oil imports on a net basis. In 2019 net oil imports accounted for less than 3% of US oil demand, well down from the peak of 66% in 2006. On a gross basis, the US still imports significant volumes of oil, around 9m b/d, mainly "heavier" crude oil that US refineries are configured to process, but last year it exported almost as much, 8.5m b/d, mainly oil products and "lighter" shale oil for processing elsewhere. The US Energy Information Administration expects the US to become a net oil exporter in 2020, with exports exceeding imports for the first time on an annual basis for several decades.

Economic and geopolitical dividend

The steep rise in American hydrocarbons production has resulted in economic benefits for the US, narrowing the deficit in its energy trade balance to just $3bn in 2019 from $274bn in 2010. The energy boom has also boosted economic activity in US regions where it has occurred, contributing to employment in traditional oil and gas producing states such as Texas and Oklahoma, and others such as Pennsylvania and North Dakota. According to the Federal Reserve Bank of Dallas, the US shale boom contributed to 10% of US GDP growth between 2010 and 2015.

The country's once heavy reliance on oil imports was seen to undermine national security interests, especially when oil prices were high, in that it limited the US' ability to act against energy-exporting adversaries such as Iran, Venezuela, and Russia, while staying dependent on others, such as Saudi Arabia. However, this narrative has been transformed by the shale boom. Now, the view is that the US is empowered to act more decisively against energy-exporters it finds problematic, as their influence over energy markets has been eroded.

Both narratives, whether of total weakness or unrivalled strength, have overstated the case, but there have been geopolitical dividends for the US becoming a leading oil (and gas) producer. The re-imposition of sanctions against Iranian oil exports by the Trump administration is a case in point, where Iranian barrels were taken out of the market with little impact on prices, partly due to higher US oil production being able to soften the impact. Furthermore, the ability of OPEC to manage the oil market to suit its interests has been somewhat weakened, as evidenced by US shale production recovering from the 2014-16 oil price slump once OPEC and Russia agreed in late 2016 to cut output to keep prices buoyant.

The US shale boom has boosted the American economy, generally contributed to a lower oil price ceiling, and enhanced its geopolitical leverage. However, the US' status as a leading oil producer has not made it immune from volatility in the global oil market, and the actions of other players in it, as recent events have shown.

US shale's vulnerability to very low prices

Prior to the US shale boom, low oil prices were seen as a clear benefit to the US economy, with lower fuel costs good for individual and industrial consumers while reducing the energy import bill. Low prices might not have been good for the US oil sector, but cheaper petrol at the pump trumped the interests of local producers. But with the US doubling output, oil sector interests have become significantly more important. Low oil prices are still a macro-economic net positive for the US, but regions that have benefitted from the oil boom will face falling production, financial pressure, lower investment and reduced employment. Hence the anxiety in the US oil sector, and among some US policymakers, over the failure of OPEC and Russia to continue their output-cutting agreement, worsened by the prospect of a prolonged market share war at a time when the COVID-19 pandemic threatens to cause oil demand to contract.

The combination of supply and demand factors have pushed Brent to lower than $30/bbl in mid-March from around $52/bbl at the start of the month, a price environment that is not sustainable for many US shale producers. The sector had already been showing signs of strain, being highly leveraged with debt and with investors demanding tighter capital discipline in the face of weak profitability. US production has benefitted from OPEC and Russian co-operation to keep prices at well above $50/bbl, growing by well by over 3m b/d in the last three years. But in the absence of this cooperation, shale producers will be forced to severely cut back their operations if prices do not recover until the longer term, and producers in a weaker financial position will not survive.

Recognition of a potentially severe slump was reflected in calls for the Trump administration to bail out the shale sector, with proposals ranging from low interest loans to tax breaks. A group of Republican senators also wrote a letter to the Saudi Arabian leadership on March 17 asking it to "assert constructive leadership to stabilise the world economy," presumably by not hiking output, while another senator has called on the White House to ban oil imports from OPEC states and Russia. To date the only effort the US administration has made to assist the US oil sector is to purchase crude to replenish the Strategic Petroleum Reserve, although President Trump said on March 19th that he might intervene "at an appropriate time" to remove the threat of a prolonged price war between Saudi Arabia and Russia. What that would entail, however, is yet to be determined.

Target of geopolitical retaliation

One of the reasons for Russia to end co-operation with OPEC was that it was wary of US producers continuing to benefit from the OPEC+ output cuts. Russia reportedly wanted US producers to adopt greater responsibility to shore up prices, by cutting back their own output, rather than take advantage of restraint being made by others (even though Russia's compliance with its agreed targets was lax). Russia's rationale could also be the result of US sanctions that have targeted its energy sector since 2014. More recently, US sanctions have delayed the completion of the Nordstream 2 offshore gas pipeline from Russia to Germany, and targeted Rosneft's trading arm for trading Venezuelan oil. Furthermore, as an emerging exporter of liquefied natural gas, the US has also been eyeing Russia's traditional gas markets in Europe. Russia's actions to split from OPEC thus appears to be partly motivated by wanting US shale producers to share the burden of shoring up prices, while also sending a message that it, too, can use energy as a geopolitical weapon. As much as higher US oil production might enhance US geopolitical leverage in some cases, it can also lead it to be more exposed to retaliatory action in others.

Conclusion

US shale producers had benefitted from prices kept buoyant by OPEC-Russian co-operation, but are now in a vulnerable position as this has ended, at least for the time being. Shale operators will exercise tighter control on capital expenditure as the availability of finance is wound back. The Economist Intelligence Unit expects this to put considerable pressure on US output growth in the future. There is even the possibility of output contracting year-on-year if prices do not recover. Russia and Saudi Arabia cannot make US shale go away, but have shown that the US can still be impacted by the actions of other players. The shale boom has resulted in American economic and geopolitical dividends, but also exposes its energy sector to other major oil producers who have their own strategic agendas. Despite the narrative of energy dominance, the US remains part of a global oil market that is as interdependent as before, where individual producers – even significant ones – remain prone to events outside their control.